PetMed Express, Inc.
There are many things to like about PetMeds. The company has outstanding financial metrics, with over $70 million in balance sheet cash vs. no debt. The business model is very efficient, with low capital requirements leading to high returns on capital. Average 5-year return on equity is over 28%, with return on assets averaging an impressive 26%. Management has been generous about returning capital to shareholders, also. Share count has been reduced by over 2% annually over the past 3 years, and the dividend was recently boosted 25%, yielding an attractive 3.2% at current share prices.
Since 2006, the company has also generated solid growth in both revenues and margins. 5-year compound annual growth (CAGR) rate in revenue is 11%, and operating margin rose from 13.2% in fiscal 2006 to 17% in fiscal 2010 (March), leading to a 15% CAGR in operating earnings.
Vets control over 75% of this $3.5 billion dollar market. PetMeds has been able to achieve success through classic retail standbys - lower prices, better selection, and superior customer service. PetMeds generally offers prices 10-15% below the vet's office, and its wide array of products can help customers find less costly or higher quality alternatives for non-prescription needs. Using these advantages as a foot-in-the-door, PetMeds has enjoyed strong repeat business, helping to drive decent and profitable growth.
The company's strong financial health, shareholder friendliness, and decent position in a niche market lead me to give it a positive recommendation, but I do believe there are better choices in Magic Formula Investing (MFI) right now. Let's take a look at why...
The biggest problem with this company is that it looks like it has stagnated. Revenue growth is going in the wrong direction - last quarter it fell 2% from the 2009 quarter, not impressive when you consider the recessionary conditions last year. Even worse was profitability. Operating margins declined to 12.6%, vs. 15.7% a year ago, leading to a 21% decline in operating income. It was the second quarter in a row that the company suffered declines. The business trend, as they say, is not our friend here.
It appears that new competition from all sides is taking its toll. Customers can now drive to Walmart (WMT) or click to Amazon.com (AMZN) and find the same pet medications for even cheaper than PetMeds offers them. Direct competition has also emerged from companies like Drs. Foster & Smith, another online pet outfit which has managed to both under-price PetMeds on pharmaceuticals and offer other pet supplies as well. This new competition is in addition to PetMeds' historical nemesis, the vets themselves. Vets have dropped their prices on meds and have continued to discourage customers from purchasing pet medications online.
Against these threats, I haven't seen anything from management that indicates they have a plan in place to re-ignite growth. The dividend hike and another new $20 million share repurchase will appease some shareholders, but the fact is that the stock isn't worth much more than it trades at today without growth. The problem is that it isn't clear what management can do to ease the issues they are currently experiencing. Better marketing (PetMeds advertises on the cheap) may help the top line, but would cut further into margins. Lowering prices is probably not a good strategy, considering the scale and diversity of its big-box competitors. The company operates at a competitive disadvantage.
I'm afraid PetMeds is likely to experience declining metrics for a few years before bottoming out at a reduced level of profitability. Even giving the company the benefit of the doubt and modeling in meager growth, my fair value estimate is only about $17 per share, an 11% premium (with the dividend) to current prices.
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Steve does not own PETS.
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